'Be prepared to pull the trigger': why the risk of a market crash is high

I wouldn't want to scare you but have you seen a chart of the Dow Jones or the S&P 500 index recently? The RSI or Relative Strength Index, a technical indicator used by chartists to measure the speed and change of price movements, is at record highs.

In the technical world the RSI goes from zero to 100 and if a stock has an RSI below 30 it is described as "oversold", and if the RSI is over 70, it is described as "overbought".

While individual stocks are quite volatile and can regularly appear as oversold and overbought, an index like the S&P 500 index, which represents the average of 500 stock prices, is, by definition, not volatile and rarely becomes either oversold or overbought.

At the moment the RSI for the S&P 500 index is trading at 87.9. The Dow Jones RSI is currently 90.5. That means they are both overbought, which is rare enough, but more significantly, I can't see that they have ever seen an RSI number this high, even in the tech boom, ahead of the 1987 crash, or before the global financial crisis. The momentum behind the US markets has never been higher than now.

On top of that, the S&P 500 price earnings ratio is now at 24.87x; that is the highest since the tech boom and higher than pre-GFC. I own a couple of businesses and I have to tell you, if someone wanted to come and pay me 24.87x post tax earnings for either of them I would retire a gazillionaire. Yet this is the average, repeat, average, valuation of $US25.12 trillion, repeat, trillion, dollars worth of US stocks in the S&P 500.

There has rarely been such positive sentiment. Trump-inspired of course although there are a myriad of other factors you could list to justify it in the short term, anything from economic recovery to anticipation of a solid results season which is ongoing in the US.

I made the mistake in October last year of getting cautious about the US market having a correction. That was 1000 points ago (idiot!), the fastest 1000 point rise in the Dow Jones ever.

As I wrote in October, the year or two ahead of a stock market crash can be quite phenomenal. When you talk about the average return on the All Ordinaries Index being 5.7 per cent a year before dividends, that hides the fact that much of that average number comes from a couple of years of really phenomenal, often exponential market performance, which then inflates the average calculated over many more boring years. The point being that if you don't ride the waves up as far as they go you will never achieve that average. So this is not a time to sell everything and sit back wagging your finger and telling everybody else it is going to end in tears. You have to ride these moments to the last breath.

Your job then, is to simply take advantage of it for as long as it lasts, call the top when it comes and until then don't bother making some un-makeable prediction that it will all end badly which will make you get out before the end.

All you need to do for now is note that the risk of a correction is high not low and because of that you need to sit on the edge of your seat, turn your screens on every day, and be prepared to pull the trigger and sell quickly should your guts ever tell you to.

I have our portfolios almost fully invested at the moment, but I have them on a hair trigger. When I see Wall Street fall a few hundred points in one night I will quietly start selling. This herd could turn nasty at any time and with the top of the S&P 500 long-term trading range 17 per cent below where we are now, we could see a 10 per cent correction in the US markets for absolutely no fundamental reason at all, other than the herd deciding to have a sentiment change for some invisible reason, which is usually because some large fund manager somewhere holds an asset allocation meeting and decides to sell, and the rest follow.

It can happen any day. But don't be too smart for your own good by selling before it happens. These exponential moments only come around once every decade and you can't miss them.

Marcus Padley is the author of the daily stock market newsletter Marcus Today. For a free trial of the Marcus Today newsletter, please go to marcustoday.com.au